January 23, 2006

What is the Coase Theorem, really?

Each year I teach a Master's/Ph.D. level class in Environmental Economics. One topic I always struggle with presenting is the Coase Theorem. Not because it is overly complicated. There are just so many versions of it that I don't know which one to present.

WARNING: Long post ahead. This is my attempt to straighten out a bunch of confusion I've caused over the years in teaching the Coase Theorem. If it sounds like a classroom lecture, that's because it is.

I blame Coase really. If he would have just been kind enough in 1962 to write down the theorem explicitly, he would have saved me a lot of time and trepidation--there are few things more frustrating than standing in front of a group of people trying to explain something they each think they already know, yet each has a slightly different understanding of it. Let me walk through a few of the versions and see if I can explain my frustration. I will frame each in the context of a local pollution problem.

The Coase-Theorem: The free-market version

This is the version I usually present to undergraduate classes when I am trying to convince them that there are market based approaches to solving environmental problems. The focus here is on property rights. The firm pollutes because it feels like it has the right to. The victim feels she has the right to clean air. Without a resolution of the property rights dispute, there will always be a socially inefficient amount of pollution produced. So this version of the Coase Theorem goes something like this:

As long as both parties are free to bargain, the final amount of pollution will be independent of the initial allocation of property rights.

In other words, the problem is not that the polluter is polluting. The problem is that both the polluter and the victim thinks their position is justified. The market fails to fix the problem because no one--or both parties--has the property rights. In this version of the Coase Theorem, the role of the legal system is to simply decide who gets the property rights. Because bargaining is assumed to be free, it doesn't matter who gets the property rights, just assign them to either the polluter or the victim and let the market work. We will always get an efficient solution.

This version of the Coase Theorem fits nicely after a lecture on taxes and subsidies for solving pollution problems. In this simple world, a properly set tax on emissions, or a properly set subsidy on pollution abatement will both give the exact same final amount of pollution. The tax or the subsidy act as a price for pollution. The Coasian bargaining solution does the same thing, only it allows the market to set the price for pollution. The market solves the problem.

But, there are a lot of assumptions embedded in simple version of the Coase Theorem. So many that Coase himself wrote a piece in 1988 to debunk the simple version. In effect he wrote 'That's not what I meant.'

The Coase Theorem: The fair market version

My reading on Coase's intent is that he was really trying to clarify the conditions under which bargaining might or might not resolve a property rights dispute efficiently. This version of the Coase Theorem makes explicit one of the conditions that might keep the market from efficiently solving the pollution problem: Transactions costs. Here's my version:

In the presence of transactions costs, the final amount of pollution depends on the initial allocation of property rights.

The focus here is on the transactions costs. That is any impediment to bargaining. Take the case where the victim is assigned the property right. The free-market version of the Coase Theorem says that the victim will be willing to sell that right up until the point where the monetary damage from one more unit of pollution exactly equals the amount the polluter is willing to pay for it. With transactions costs, the victim must also recoup the bargaining costs in addition tot he damages. The result is less pollution than we would get without the transaction cost. But, if the polluter has the property right, the transaction costs cause more pollution relative to the free-market version. We get a different amount of pollution depending on who gets the initial property rights.

The legal system now has a bigger impact. The outcome ends up tilted towards the side with the initial property right. In this case, the free-market version of Coase is a corollary--created by assuming away transactions costs.

These are probably the two most popular versions of the Coase Theorem. They focus attention on property rights and transactions costs, and the debate usually turns on whether we can assume away transactions costs. But the debate shouldn't stop there. The Coase debate serves to focus attention on a number of assumptions that need to be looked at before we declare a victory for the free market. Here's a brief discussion of two:

The Coase Theorem: The wealth effects version

The two versions of the Coase Theorem presented above ignore the possibility that the bargaining outcome creates wealth for the owner of the property right. If I have the right to clean air, any income I receive from selling that right might increase my demand for clean air. Just like getting a raise at work increases my demand for eating out, getting more money from selling my right to clean air might increase my demand for clean air. Likewise, increased profits to the polluter from selling pollution rights might increase the demand for emissions. Similar to the transactions cost case, the final outcome depends on the initial allocation of property rights.

The Coase Theorem: The free entry version

Further, the increase in profits from selling the property right might lead others to want to take advantage. If firms are free to enter the market, the assignment of property rights to the firms and the resulting profits from the sale of those rights might cause other polluting firms to enter the market. Similarly, assigning property rights to the victim, and creating wealth through bargaining might entice new victims to enter the market--for example, more people might move into a polluted neighborhood as a result of the increased wealth from the sale of property rights. The simple versions of the Coase theorem assumes away entry--by both new firms and new victims.

I'm sure I'm ignoring other issues, but this is a blog and not a textbook. The Coase Theorem is usually presented separately from other market based solutions to environmental problems. However, the real beauty of the Coase Theorem is that is focuses attention on the assumptions needed to make market based solution work--or fail. Wealth effects are not unique to bargaining solutions: Taxes and subsidies have the same problem. Taxes on pollution create potential wealth for the victim and abatement subsidies create wealth for the polluter. If victims are compensated proportionately to their damages victims have the incentive to incur more damages. Similarly, subsidies create a potential incentive for new firms to enter the polluting industry.

The conditions highlighted by Coase are not unique to bargaining solutions. And that is the real benefit of talking about Coase. Instead of trying to figure out the right amount of pollution, we now focus our attention on the set of conditions that help or hinder market based solution to environmental problems.

Comments

What is the Coase Theorem, really?

Each year I teach a Master's/Ph.D. level class in Environmental Economics. One topic I always struggle with presenting is the Coase Theorem. Not because it is overly complicated. There are just so many versions of it that I don't know which one to present.

WARNING: Long post ahead. This is my attempt to straighten out a bunch of confusion I've caused over the years in teaching the Coase Theorem. If it sounds like a classroom lecture, that's because it is.

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